How should your credit union react to the changing auto loan landscape?

By Bill Vogeney06.15.2017

There’s no doubt the auto loan market is changing. The big banks are pulling back on volume, tightening credit quality. Sub-prime lenders are concerned because delinquency is at the highest level since the Great Recession. Used car values are declining, increasing the magnitude of loss for all lenders.

I was inspired to write this based on an email I received from a fellow member of the Lending Council. Here’s what my colleague shared with me:

Bill, read your article on the deterioration of the auto lending space. (Actually it was a comment I had made on Linked In, responding to this article:  http://www.businessinsider.com/wall-street-is-worried-about-car-loans-2017-3 ) It was quite relevant, and the timing was good. I was just talking to my CEO last week about how we may want to shift our focus away from auto lending. It appears that the auto has increasingly become a part of our "throw away" society. Supply is far outpacing demand, and the values are plummeting. Great commentary by you. Thanks!

I have been warning those who have been willing to listen that the last few years we have experienced the ‘Golden Age’ of auto loan performance. First of all, after the financial crisis, we heard from the credit bureaus that consumers had prioritized their car loan payments ahead of their mortgage payment due to the housing crisis. Secondly, when lenders have had a repossession, strong demand and a somewhat limited supply of good used cars allowed them to get top dollar on the sale of the vehicle compared to historical averages. Ent’s historical average for recovery based on the balance at the time of repossession has been around 50%. The last few years this number has been closer to 60%. There are other factors that can drive this including age of vehicle, LTV and term, but we’ve actually been taking a little more risk than historical averages. All of this, as I have pointed out many times, was unsustainable.

In the meantime, a lot has changed. Leasing came roaring back, and all of a sudden there are a lot of two and three year old cars on the market, an issue we didn’t have to worry about 24 months ago as newer used cars were selling for a premium. Outstanding auto loans have been growing at breakneck speed, as pent up demand for a new or newer car caused car sales to increase fairly dramatically. The end result? Auto loan indebtedness as a whole has increased far faster than personal incomes. And finally, perhaps consumers have re-prioritized their mortgage payment since home values are have increased dramatically in many markets.

While used car values are declining and as a result you’ll experience higher losses on a repossession, there are other impacts. It helps to understand the psyche of certain consumers and their behavioral patterns. When homes prices plummeted from 2007-2011, many consumers made totally irrational decisions to stop paying their mortgage because they were upside down, even though they could afford the payment and were paying their other debts. That was termed a ‘strategic foreclosure.’ Consumers often do the same thing with their cars. If they’re dramatically upside down, it’s not as easy to justify writing a check to pay for necessary maintenance or repairs. When they want to trade in their car, they find they can’t, because at the same time lenders are pulling back on criteria such as loan-to-value. Yet, auto credit is still readily available, so some of these upside down borrowers will buy another car and turn in their albatross with four wheels to the lender. Ent certainly experienced a lot of this in 2007 and early 2008 because of negative equity made worse by skyrocketing gas prices.

Falling prices for used cars are magnified because we’re coming off five years of very strong used car values. In essence, a member looking to trade their used car purchased in 2014 ‘bought high,’ and are now ‘selling low.’ That really adds to the gap between what they owe on their car and what it’s worth. As I previously pointed out, you’ll also have more repossessions on top of higher losses per car, even at a time when the economy is still expanding.

You’re probably thinking, “Bill, so what does that have to do with how I should react to all of this news?” First, my personal, subjective thoughts. I’m not a believer in making big adjustments to credit policy over a short period of time. I like incremental changes. However, if you really loosened your guidelines over the last five years, unfortunately in the next year or so I think you’ll need to tighten them quite a bit.

Now, for the objective process. First of all, really focus on your historical losses and spreads for lower credit tiers and adjust your pricing to reflect this return to normalcy. Look at it this way: If you have a loss ratio of 20 basis points for A+ new car loans, and due to falling auto prices you estimate your losses per car will increase 25%, you’re only talking about an extra 5 basis points in losses. If that’s the case, raise your rates .10%. For a C tier used car loan that has had a 2.5% loss ratio over the last few years, that extra loss from lower prices will probably cause you to widen your spread another 75 basis points. There is no real need to stop making C loans.

Next, use your data to narrow your focus on the loans that are causing you the most heartache. At Ent, we’re watching a 2014 pool of C tier used car loans that have not performed well from the start, when our loan underwriting slipped a bit. Less than 10% of our overall volume for 2014 is causing 40% of our losses. In reviewing different underwriting criteria, we isolated that debt to income exceptions were the cause. The other 90% of our volume in 2014 for C used car loans is performing as expected.  In addition, this type of analysis can help in prime score ranges as well. We’ve found that less than 3% of our prime volume is causing the vast majority of losses-and that pocket of risk is coming from high FICO score, high LTV (over 120%) 84 month car loans. We placed too much emphasis on the score, and not enough on reality: high LTV loans and 84 month terms don’t mix well. Yet even though we’re seeing this occur, our risk premiums of almost 125 BP on an 84 month loan (compared to a 60 month loan) are covering the losses for now. No substantial changes needed, thank goodness.

In addition, look at the collateral you’re lending on. One of the observations I made back in 2010-2011 was the impact of the Cash for Clunkers program. A lot of older, used cars were taken off the market. If you consider the most marginal of consumers (from the standpoint of Economics) who need financing, the Buy Here, Pay Here buyers, they were the market for a lot of these C4C cars. When dealers had a hard time finding these cars, they had to buy nicer, more expensive clunkers. That took away some supply from what you might consider to be more mainstream buyers and dealers. Six years ago, I noticed that our local dealers were more likely to be stocking older, higher mileage vehicles, which supported by theory about the impact of used car supply.

Finally, my Lending Council friend relayed to me:

We are looking at some tweaks with LTV’s and spread, but our market is a highly competitive auto lending market. To be relevant we need to remain in, or at least on the fringes of the sweet spot. What’s most concerning to me are the deflating values. Oh well…that’s the biz right? No resting on laurels anymore!

I absolutely agree. We’re ALL in a competitive marketplace-that’s typically something I hear from all of my lending friends. We certainly can’t be complacent as there is no magic bullet. You can’t rely solely on pricing, LTV, or underwriting. Spreading out your changes between different elements of risk, and spacing them out time-wise, will help you remain competitive but also ensure that you can continue to make loans profitably. Balancing competitiveness and sustainability of your credit standards will lead to somewhat sustainable volume.

Bill Vogeney is Senior Executive Vice President, Lending and Finance, for $4.8 billion Ent Credit Union, Colorado Springs. He has been a CUNA Lending Council member since 1999 and was the chair of the executive committee for 2013-2014. He can be reached at bvogeney@ent.com.

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